How are share prices set?

By Jean Folger AAA
A:

When a company goes public though an initial public offering (IPO), an investment bank evaluates the company's current and projected performance and health to determine the value of the IPO for the business. The bank can do this by comparing the company with the IPO of another similar company, or by calculating the net present value of the firm. The company and the investment bank will meet with investors to help determine the best IPO price through a series of road shows. Finally, after the valuation and road shows, the firm must meet with the exchange, which will determine if the IPO price is fair.

Once trading starts, share prices are largely determined by the forces of supply and demand. A company that demonstrates long-term earnings potential may attract more buyers, thereby enjoying an increase in share prices. A company with a poor outlook, on the other hand, may attract more sellers than buyers, which can result in lower prices. In general, prices rise during periods of increased demand - when there are more buyers than sellers. Prices fall during periods of increased supply - when there are more sellers than buyers. A continuous rise in prices is known as an uptrend, and a continuous drop in prices in called a downtrend. Sustained uptrends form a "bull" market and sustained downtrends are called "bear" markets.

Other factors can affect prices and cause sudden or temporary changes in price. Some examples of this include earnings reports, political events, financial reports and economic news. Not all news or reports affect all securities. For example, the stocks of companies engaged in the gas and oil industry may react to the weekly petroleum status report from the U.S. Energy Information Administration (the "EIA report").

Stock prices can also be driven by what is known as herd instinct, which is the tendency for people to mimic the action of a larger group. For example, as more and more people buy a stock, pushing the price higher and higher, other people will jump on board, assuming that all the other investors must be right (or that they know something not everyone else knows). There may be no fundamental or technical support for the price increase, yet investors continue to buy because others are doing so and they are afraid of missing out. This is one of many phenomena studied under the umbrella of behavioral finance.

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